American Option Pricing with Transaction Costs

Posted: 25 Apr 2005

See all articles by Valeriy Zakamulin

Valeriy Zakamulin

University of Agder - School of Business and Law

Abstract

In this paper, we examine the problem of finding the reservation option prices and corresponding exercise policies of American options in a market with proportional transaction costs using the utility-based approach proposed by Davis and Zariphopoulou (1995). We present a model in which the option holder has a constant absolute risk-aversion. We discuss the numerical algorithm and propose a new characterization of the option holder's value function. We suggest original discretization schemes for computing reservation prices and exercise policies of American options. The discretization schemes are implemented for the cases of American put and call options. We present a study of the optimal transaction policy of the option holder. We examine the effects on the reservation option prices and the corresponding exercise policies of varying the levels of absolute risk-aversion and transaction costs.

Keywords: American options, American option pricing, option pricing, reservation option prices, utility-based approach, numerical algorithm, optimal transaction policy

Suggested Citation

Zakamulin, Valeriy, American Option Pricing with Transaction Costs. Journal of Computational Finance, Vol. 8, No. 3, pp. 81-115, Spring 2005. Available at SSRN: https://ssrn.com/abstract=708104

Valeriy Zakamulin (Contact Author)

University of Agder - School of Business and Law ( email )

Service Box 422
Kristiansand, N-4604
Norway
+47 38141039 (Phone)

HOME PAGE: http://vzakamulin.weebly.com/

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